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Localization Barriers to
Trade: Threat to the Global
Innovation Economy
Executive Summary
BY STEPHEN J. EZELL, ROBERT D. ATKINSON, AND MICHELLE A. WEIN
SEPTEMBER 2013
EXECUTIVE SUMMARY
The global economic downturn has intensified pressure on governments to boost their
countries’ sagging growth rates. Unfortunately, this has led increasingly to policymakers
turning to a range of trade-distorting mercantilist measures intended to generate growth in
the short-term by reducing imports and/or increasing exports. This explains why the
number of technical barriers to trade reported to the World Trade Organization in 2012
reached an all-time high. In particular, a rapidly growing number of countries, including
Argentina, Brazil, China, and India (among many others), have come to embrace a new
kind of mercantilist trade policy that seeks to pressure foreign enterprises to “localize”
economic activity so that these countries can create domestic jobs. These localization
barriers to trade (LBTs) pressure foreign enterprises to produce locally what they would
likely produce elsewhere and export to the recipient nation.
Though LBTs can produce some short-term gains for economies, in reality they are not an
unalloyed good, and they are downright harmful to the global economy. Moreover, when
countries resort to competing by using LBTs, they often neglect the superior opportunity
to enact a range of pro-innovation and pro-productivity policies that can spur innovation
and productivity across all industries.
A FRAMEWORK FOR UNDERSTANDING GLOBAL ECONOMIC
DEVELOPMENT POLICIES
There are essentially four types of economic development policies that countries are
currently implementing. (See Figure 1) Three have as their central aim the mercantilist goal
of accelerating growth by reducing imports and/or increasing exports. The policies are:
1. “Localization barriers to trade”: These policies pressure foreign firms to shift
production and/or intellectual property (IP) to the nation implementing them.
These include local content requirements, forced offsets, and forced IP or technology
transfer as a condition of market access.
2. “Indigenous innovation”: These policies provide preferential treatment of domestic
enterprises at the expense of foreign ones. Policies include providing benefits only to
domestically owned firms, making it more difficult for foreign enterprises to compete
locally, such as by using domestic technology standards or onerous regulatory
certification requirements; or blocking foreign competitors from domestic markets.
3. “General mercantilism”: These policies, such as currency manipulation or high tariffs,
seek to boost production by increasing exports and/or reducing imports—by making
imports more expensive and exports cheaper—but they are indifferent as to whether
they affect domestic or foreign enterprises.
4. “Enterprise support”: These policies seek growth through higher productivity and
increased innovation—regardless of whether the sector is “traded” or not—and aim
more to assist, rather than coerce, enterprises. While virtually all countries have policies
in this category, for an increasing number the relative “share” of these policies has been
shrinking.
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Figure 1: A Matrix for Understanding Global Economic Development Policies
LOCALIZATION BARRIERS TO TRADE
LBTs can be classified into four major categories—local content requirements, local
production as a condition of market access, forced offsets, and forced intellectual property
or technology transfer. All place geographic restrictions on the location of economic
activity.
Local content requirements—the most common and rapidly growing type of LBT—
mandate that a certain percentage of goods or services sold in a country be produced with
local content. In 2010, LCRs affected 5 percent, or $928 billion, of the $18.5 trillion total
global trade in goods and services. LCRs lead to an estimated reduction in world trade of
almost $100 billion per year. Countries define “local content” in a variety of ways, such as
the percentage of local components used in the assembly of a final product; the share of
locally developed IP embodied in the development of a product or service; or even the
share of locally produced content in the broadcasting and audio/visual sectors. Countries
apply LCRs to both public and private procurement and they affect virtually all sectors of
economic activity, from information and communications technology (ICT) products,
energy, and life sciences to digital services. For example, India’s Preferential Market Access
(PMA) mandate will require that foreign enterprises incorporate 25 to 40 percent local
content if they wish to serve India’s public ICT markets.
Another form of LBT mandates local production of a product or service as a condition of
market access. For example, requirements that enterprises must use local ICT
infrastructure—such as local data centers—to provide digital services such as Internet
search to an economy effectively manifest a requirement of local production as a condition
of market access. Some two dozen countries have introduced local data center or related
data storage requirements. For instance, Vietnam’s Decree 72, which took effect in
September 2013, mandates that all Web-based services providers (e.g., Facebook and
Google, etc.) operate at least one data center in Vietnam.
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Forced offsets encompass a range of industrial compensation arrangements required by
foreign governments, historically as a condition of public procurement contracts, though
now increasingly as part of private-sector procurements. For example, Japan, India, and
Israel have required forced offsets as a condition of their countries’ airlines purchases of jet
aircraft, while others such as Turkey are seeking to do so.
Finally, requirements that foreign enterprises transfer intellectual property or technology as
a condition of market access—often as part of required joint ventures—have become
increasingly widespread. Such requirements constitute LBTs because they force companies
to give up technology or IP as a condition of competing in a country. For example, China
has imposed forced technology transfer requirements on foreign enterprises seeking to
compete in dozens of markets, from automobiles and high-speed rail to steel and renewable
energy. In life sciences, many nations have turned to compulsory licenses that mandate the
transfer of intellectual property to a country’s own domestic manufacturers so they can
produce goods (i.e., pharmaceutical drugs) in country.
WHY LOCALIZATION BARRIERS TO TRADE ARE HARMFUL
LBTs inhibit global economic growth, especially in innovative industries. They are harmful
for three reasons. First, LBTs hurt the economies not using and affected by them, lowering
their growth and often in turn encouraging LBTs in response. Second, LBTs damage the
global economy, particularly by lowering the amount of innovation. Third, while LBTs are
intended to benefit the countries that field them, in reality they can backfire and damage
these countries’ own economic growth.
LBTs Harm the Nations Affected by Them
LBTs injure the foreign enterprises affected by them. LBTs force these enterprises to
produce in locations where they otherwise likely would not if the location production
decision was made by purely economic factors alone. If it made economic sense to localize
production in the destination country, enterprises would have already done so. Thus,
coerced local production raises firms’ costs, meaning lower profits and less investment in
those enterprises’ home nations, which limits firm growth, resulting in fewer jobs and
lower profits, both at the enterprise and ultimately country level.
But LBTs also harm third-party nations. For example, China’s extensive use of LBTs has
distorted global trade and investment patterns and significantly harmed other developing
nations, such as Brazil and India, which might have received some of the investment and
gained some of the global market share. Not only has this meant slower economic growth
in these third-party nations, more troublingly it has encouraged these nations to ramp up
their own LBTs in response.
LBTs Harm the Global Economy
LBTs don’t just harm particular economies; they hurt the global economy, particularly by
leading to relatively less innovation produced by innovation-based industries, such as ICTs,
life sciences, clean energy, and aerospace. Because innovative industries are characterized by
relatively high fixed costs of initial R&D and design but relatively lower marginal costs of
incremental production, innovation industries need access to large, global markets, which
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enables them to cover their high fixed costs. But LBTs introduce market balkanization that
limits scale economies. For example, a biopharmaceutical firm may only need a single plant
to produce a drug for global distribution, but if nations require the firm to manufacture
locally in order to sell locally, then it will need multiple plants, thus increasing the firm’s
costs, which both makes the drug unnecessarily more expensive for patients (globally) and
reduces the resources available for reinvestment in future generations of innovation.
Second, LBTs introduce excess competition that can reduce innovation. Indeed, in some
industries, too much competition can actually lead to reduced innovation. For example,
China has used market-distorting LBTs such as forced technology transfer to help launch
COMAC as a competitor to jet aircraft manufacturers Airbus and Boeing. But if these
unfair policies allow COMAC to become successful, the result will be reduced revenues for
Airbus and Boeing to invest in next-generation aviation innovation.
Third, weak IP protections compromise innovation by allowing competitors to obtain an
innovator’s IP at less than the fair market price, thus allowing them to siphon off sales that
would otherwise go to innovators—and generate profits that could then be reinvested back
into the next generation of innovative products. LBTs thus represent a perilous threat to
the effective functioning of the global innovation economy.
LBTs Can Harm the Nations that Implement Them
Although LBTs appear as if they would benefit the countries that institute them, in reality,
they can harm these economies. First, LBTs tend to raise the cost of key capital goods
inputs, such as ICTs, which make a wide variety of industries using capital goods less
productive and innovative. Second, LBTs damage countries’ participation in global value
chains for the production of high-technology products. Third, LBTs act often as a hidden
tax on consumers and other businesses. Fourth, LBTs reduce the attractiveness of the
nation as a location for foreign direct investment. Fifth, LBTs isolate countries from the
global economy and tend not to achieve their intended effects in the manner countries
desire. Finally, LBTs are harmful because they distract countries from implementing the
right types of policies to grow their economies. For, in reality, using LBTs is a second-best
option for countries—far better if their enterprises successfully compete and win in global
markets on a best-value basis.
THE RIGHT GROWTH AND INNOVATION PATH
Instead of pursuing trade-distorting measures such as LBTs as part of an economic
development strategy predicated on export-led growth, countries could achieve far more
robust and sustainable economic growth if they embraced productivity and innovationbased economic development models. The foremost goal of such policies should be to
boost productivity growth across-the-board in all industries, traded and non-traded alike.
This is because the lion’s share of economic growth for almost all nations comes not from
changing the sectoral mix to higher-productivity industries, but from all industries and
organizations, even low-productivity ones, boosting their productivity.
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In order to truly maximize growth in the innovation-based global economy, nations would
be better served by putting in place broad-based innovation and productivity policies along
the lines of the economic growth policy pyramid depicted in Figure 2.
Figure 2: The Economic Growth Pyramid
At the base level are key framework conditions: factors such as the rule of law; effective
government; a culture of trust; effective protection of property, including IP; and
adequately competitive markets. The next level above these basic framework conditions
includes an effective tax, trade, and regulatory environment, including both social (e.g.,
environmental) and economic (e.g., industry) regulations. These policies must be
predictable and measured: tax rates that are too high or regulations that are too onerous can
stifle growth. The next level above comprises key factor inputs including robust physical
and digital infrastructures; a skilled workforce; and investment in knowledge creation. Yet
even these are not enough to achieve success. Indeed, with more nations realizing that
mastery of these three levels is what is needed just to “be in the game,” success requires
going beyond this, to a fourth level, that includes effectively crafted innovation and
productivity policies specifically tailored with regard to a countries’ competitive strengths
and weaknesses. Policies in this category include R&D tax credits, specialized R&D
institutes, support for regional innovation clusters, assistance programs for small and
medium-sized businesses, and ICT policies such as e-health and e-government.
A STRATEGY FOR ROLLING BACK LBTS
Despite the fact that LBTs so often fail to achieve their intended aims and that superior
alternative economic growth models exist, use of LBTs grows unchecked, and thus policy
responses are needed. There are several steps that the WTO, affected countries, and the
broader global economic community can take to combat LBTs:
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The WTO should take a stronger role in enforcing existing laws regarding local
content requirements.
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The WTO should extend its dispute settlement mechanism to cover other LBTs
beyond local content requirements.
The WTO should establish a comprehensive database to track LBTs worldwide.
Nations committed to market-based trade should bring more cases addressing
LBTs to the WTO.
All new bilateral and regional trade agreements should be constructed so as to fully
eschew LBTs and other mercantilist practices (such as indigenous innovation).
The United States and the European Union should rescind a nation’s participation
in their Generalized Systems of Preferences program if the country has erected
more than incidental localization barriers to trade (or other mercantilist practices).
The U.S. Congress should establish a 40 percent tax credit for all expenditures
made by companies related to bringing such cases before the WTO. In addition,
Congress should pass legislation allowing firms to obtain Department of Justice
approval for anti-trust exemption to coordinate actions regarding technology
transfer and investment to other nations that have installed LBTs.
National and international economic, trade, and development organizations,
including the World Bank, International Monetary Fund, Overseas Private
Investment Corporation (OPIC), Agency for International Development (AID),
Millennium Challenge Corporation (MCC), Export-Import Bank, European Bank
for Reconstruction and Development, and others, should both stop promoting
export-led growth as a solution to development, and tie assistance to steps taken by
developing nations to move away from LBTs—thereby rewarding countries whose
policies are focused on spurring across-the-board productivity through nonmercantilist means.
In summary, LBTs not only represent a growing threat to the global economy but on net
appear to be sub-optimal policies for even the nations employing them. Countries would
be better served by employing a broad range of enterprise support-based innovation and
competitiveness policies.
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